Friday, January 11, 2013

Fed Returns $89 Billion to US Treasury

We were struck by this bold and encouraging headline from yesterday's news. Wow, what a performance for the Fed. On behalf of US taxpayers, thanks a million er, billion! How did you guys do it, anyway?

Well, to answer this simple question we need to understand the Fed balance sheet and its policy of open market purchases of US Treasuries. The Fed rebates the profit it receives on its holding of US Treasury bonds back to the Treasury, net of its costs. And since the Fed simply prints money, or reserves, to pay for the Treasuries it purchases, it has no cost of funds. So interest income on its portfolio of US Treasuries, minus its operating costs, minus its zero cost of funds equals $89 billion. If you want to try this at home, simply buy huge quantities of US Treasuries and pay for them with money you print in your basement. Then all you have to do is lock your doors, avoid answering the doorbell and live off the net interest income.

The Fed has created a fancy name for this: quantitative easing and we are now in version 3.0. The Fed is now actively buying $45 billion of new Treasury bonds each month (plus $40 b of mortgage backed securities). So let's review where we are and what contributed to the Fed's $89 billion windfall for US taxpayers.

First, net new issuance of Treasury bonds sold to finance the annual budget deficit for 2012, totaled $1.2 trillion. The Fed purchased roughly 80% of that net new issuance, or $960 billion. Total holdings of US Treasury bonds by the Fed now equal just under $1.7 trillion. So simple math would imply that in order to rebate that juicy profit of $89 billion to the American Taxpayer, via the Treasury, the Fed debased the US dollar by pumping a total of $1.7 trillion of new dollars into the system.

Suddenly this doesn't seem like such a great deal anymore. Watering down the US dollar for everyone to the tune of $1.7 trillion, just to earn a measly profit for the Treasury of $89 billion? Let's give this some further thought.

The total US money supply is notoriously difficult to measure, but let's use M2, generally the most accepted broad measure of money in the economy. According to the Federal Reserve of St. Louis, M2 currently stands at around $10 trillion. Let's assume further that the addition of $1.7 trillion in reserves has only a 1% impact on debasing this stock of $10 trillion (even though it amounts to 17% of M2). That's still $100 billion! So $100 billion of the purchasing power of the dollar vanished from the US economy so that the Fed could turn around and deliver a profit of $89 billion to the Treasury? That doesn't seem too smart to us.